Constellation Brands FY 3Q17 Earnings Call Notes

Constellation Brands’ (STZ) CEO Robert Sands on Q3 2017

Border adjustability could potentially disallow a deduction for foreign COGS

“One specific aspect of a proposed Republican tax reform plan called border adjustability could potentially disallow a deduction for foreign sourced COGS or cost of goods sold. As you know, our imported Mexican brands can only be authentically produced in Mexico and sold in the U.S. In order to understand how different tax reform proposals could impact our business, we have modeled several different potential scenarios that include border adjustability as well as some of the positive facets of a corporate tax reform plan based on what we know today. Overall, there are many unknowns related to future legislation and it’s still too early to make a definitive call on final outcomes and timing because the legislation has not been written. As more details develop on these policies and legislation materialized, you can be assured we are prepared to respond accordingly. As you would expect, we are closely monitoring the situation and we have significant resources dedicated to this effort.”

Consumer takeaway for products is accelerating

“The simple fact is that consumer takeaway for our products is accelerating, okay, sequentially as we look at our results. So I don’t think that we believe or see any softness whatsoever in the business and in fact I would say, it’s the opposite, okay, at the consumer level to the extent that it can be measured. We are actually seeing acceleration and I am sure that that will shake out from a depletion point of view over the medium term meaning throughout the year and into next year. So very, very, very strong results.”

Big craft brands are down a lot, everything else is rising

“And as far as craft goes, look, I mean craft is a tale of two cities, right. You can’t look at the craft number as a total number. I mean what continues to go on in craft is the major brands, Sam, Sierra Nevada, Blue Moon, which are all on the craft numbers, those continued to be down big time, right, like in the, I don’t know, about 8% range. And then you have sort of everything else which continues to be up significantly and is not being dragged by those numbers. And you have also got the, what I will call, the local effect which is a lot of the smaller local craft players eating up many of those larger older brands, which are now 25 years old.”

60% of our COGS is from Mexico

“Our understanding is that U.S. based COGS will be deductible. And right now our U.S. based component of our beer COGS, inclusive of freight, is about 40%. I mean 60% of the COGS is from Mexico. Now we have things that we can do within our supply chain over time, but we are talking about long-term supply agreements. We would have to take into account changes in freight and of course, any changes or fluctuations in currency between the countries before you make final plans like that.”

We’re at the forefront of thinking about these tax issues. The Senate side isn’t as clear right now

“Well, I think that Hatch made some comments yesterday saying that he doesn’t know yet what their view or opinion is on any of this. I have talked to Schumer myself personally and I would say that on the Senate side everybody is pretty reserved as to where this whole thing is going. So I would say that there is a lot less clarity on the Senate side than there is on the House side. And I would say we know a lot more about it than anybody else and that we are told that other companies that should be concerned about this are just waking up to the whole matter whereas we have been focused on it from the very beginning, having met ourselves with Ryan several months ago, really over the last summer. So we have been quite aware of this and thinking about it.”

Tax reform is probably a year off at best. First thing that’s going to happen is Obamacare

“I mean it’s probably a year off at best…We can only tell you what our legislators have been telling us, right. But the first thing that’s going to happen in Congress, which you are seeing right now is Obamacare…So Congress has a lot on its plate right now. And to work through all of the details and get legislation like that passed, well, Congress is telling us it’s going to be a while in any event. And it is clear cut and again this is literally what we have been told by the leaders that Obamacare is the first thing on their plate…And that’s going to take a while.”

The Mexicans are being measured

“And I guess my comment on the Mexicans and of course we do talk to the Mexican politicians as well as Peña Nieto, et cetera, et cetera. I think they are taking a measured view of the whole thing. Not necessarily being overly aggressive in their comments about what they will do other than they are prepared to engage in reasonable negotiations. And they do not believe that the U.S., in the end, will enter into or will take actions that would violate WTO principles and other principles of that nature.”

David Klein

Thoughts on how to address potential tax changes

So Dara, when we look at the tax changes and I just really want to caution everybody because we are talking to people in Congress on this topic and the border adjustability provision haven’t even been written, right. So it’s hypothetical and of course, we are trying to understand the effects that could take place, but it’s hard to get into a lot of specifics when answering. But I would say that we still would suspect that our pricing algorithm would remain consistent where it’s been in the past in the range of 1% to 2% a year and in order to mitigate any sort of a border tax, we would be more inclined to address elements of the supply chain that we would put into the deductible category. So for example, if you look at elements of our cost inputs that currently come from the U.S. that we could make deductible, I would put, say, the energy cost of producing glass in Mexico. That’s just one example of things we can do in our supply chain. So we turn that into a U.S. cost instead of a Mexican cost and we then have a deductible expense for U.S. tax purposes. We think that combined with a lower U.S. tax rate and a reasonable phase-in period for any border adjustment tax would be a more appropriate and value creating approach than to really just jump on the price lever.

Mexican COGS decline with peso. Not seeing any issues within Mexico

“Yes. So about 25% of our costs are peso denominated which disconnects a little bit from the percentage that I said earlier, so 60% of our COGS being Mexican. And the difference is dollar denominated contracts for goods that we purchase in Mexico, those contracts themselves really have an underlying FX component to them. They are denominated in dollars and it may take longer for any benefit from that to flow through. And as it relates to the Mexican economy, we are not seeing any issues from a hiring or a labor standpoint or costs within Mexico. So we are seeing no problem. We are also not seeing any significant benefits.”

This would be massive tax reform

” in terms of phase-in, the last time there was tax reform, I think the phase-in period was four years. But this sort of tax reform really isn’t about just setting up back office accounting departments to manage the new tax code. This kind of tax reform would require a time horizon that would allow companies to change their entire supply chain. So our expectation is that it would at least be four years and our objective would be to advocate to make that as long as possible so that we could actually get through up in supply agreements and so forth”

Constellation Brands 2Q17 Earnings Call Notes

Constellation Brands’ (STZ) CEO Robert Sands on Fiscal Q2 2017 Results

Could get into the food and beverage category

“there’s definitely whitespace that we think is very good whitespace that we don’t participate in. You mentioned, for instance, the F&B category. That’s a very good category in terms of its premium positioning margins and growth, so that’s clearly a subcategory that we’ll be looking at in terms of developing our portfolio for the future.”

Scale allows for a virtuous cycle

“. Look, the virtuous cycle. Our performance enables us to invest more in our businesses, in particular our wine and spirits business, which is now driving significant growth in that business and enabling us to both leverage the P&L and achieve market share growth as our focus brands are now growing at a rate that more than offsets the decline in our tail brands, which are in categories which are fundamentally not growing. So we’re over-investing. And when I say over-investing, I mean we’re investing more than we have traditionally, specifically in marketing of our wine and spirits brands”

Greater premiumization happening in the wine category

“Well, I think the category is performing very well. I think that we’ll continue to see sort of mid-single digit volume type growth in the category, right? And I think that we’ll see the spread between volume and sales and, therefore, premiumization in trade, I think we’ll continue to see that grow. I think we’re a real shift, whereas five years ago we were sort of talking, what they used to call, the super-premium category, which was the $8 to $12 range, is really being the hot and premium segment of the industry. We’re seeing a definitive shift up in that regard. And, now, you’re sort of seeing this $15-$25 segment really coming on strong, as well as segments above that. So this is what is driving the wrong of brands like Meiomi, which are about $20 a bottle, or even Prisoner, closer to $40 a bottle, is this premiumization trend, which we think is going to continue unabated in certainly the mid-term”

No interest in distribution agreements

“Distribution agreements, we have no interest in whatsoever, okay? Number one, you don’t own the brand. Number two, distribution agreements are short term. Nobody is going to sign up and give you distribution rights for a life. Number three, distribution margins are small relative to the kind of margins that we at Constellation generate through our owned brand portfolio and certainly the type of margins that we’re talking about on luxury spirits. So we don’t have really any interest at all in distribution, low margin, short-term distribution agreements that would utilize probably one of our most valuable assets, which is our sales and marketing organization. So we don’t see distribution arrangements as an add-on for the future. As I said, way, way, way too low margin and no brand equity related there too.”

Craft is over SKU-ed

” I would say that, as a general proposition, we probably think craft is over SKU-ed and over-spaced. And imports – given the importance in the growth, high-end imports are under-SKU-ed and under-spaced. And premium domestics are way over-SKU-ed and over-spaced. That’s something that we spend a lot of time sort of thinking about, which is assortment in the high end especially, and I think we’re in a very strong position to advise our retail customer through our category management initiatives as to ways that they can improve their velocity as well as their profit per-unit space that they’re devoting to beer. So that’s a big part of what we’re doing. And I think the trend that you’re alluding to is definitely occurring. And I think that that bodes really well for us in a couple of areas.”

You are going to see some shake out in Craft

“Craft, even though you are going to see some shake out there, I think that what will also occur there simultaneously is that the bigger, stronger, faster growing brands like Ballast Point will and should be given more space, more SKUs sort of for the obvious reason because it’s moving and it’s highly, highly profitable. And I think that you can say the same about imports because it’s going to become obvious to the retailer that that’s the best way to maximize, as I say, their velocity and profitability for the unit space that they’re devoting to the category”

We’re in line with inflation when it comes to price increases

“Yeah. I’m not sure that our price is really going up more than others. It’s going up to the extent that we’re taking pricing. We’re right in line with sort of the typical, I’d say, inflationary increase that occurs every year and we continue to look at it on a market by market basis. We’re probably under the 2% when we combine everything, sort of between 1% and 2%. I would say that that’s normal just to keep up with the pace of – with cost of goods and inflation and so on and so forth. So nothing different, I would say, is occurring on the pricing front – period – industrywide from what we can see.”

Constellation Brands FY 3Q16 Earnings Call Notes

Highlighting fourth consecutive year of strong stock performance

“This is the fourth consecutive year that Constellation was one of the best performing stocks in the S&P 500 Consumer Staples Index. I believe this excellent stock price performance is being driven by our strong financial results led by our beer business, which has incredible momentum and strong prospects for future growth.”

Ballast Point provides a high growth premium platform

“Ballast Point provides a high growth premium platform that will enable Constellation to compete in the fast growing Craft Beer segment, further strengthening our position in the high end of the U.S. beer market. Now Ballast Point is currently growing at more than 125% in IRI channels and remains on track to sell nearly four million cases and generate approximately $115 million in net sales for calendar 2015, representing growth of more than 100% versus the prior calendar year.”

Purchase price not crazy relative to the growth rate of Ballast Point

“so purchase price and size of the brand, first of all the purchase price is not related to the size of the brand. It’s related to the growth percentage and the size of the brand okay. So obviously the multiple that we paid for it in relationship to the growth is actually a pretty reasonable purchase price right. As you recall from my initial comments the brand grew over a 100% this year and 125% in IRI. So, when you look at purchase price at multiple as a function of growth rate, it’s pretty reasonable and we don’t see that growth rate changing much in the short term. So, we expect another pretty robust year with Ballast Point.”

Beer is becoming like wine

“Beer, okay — yes beer is becoming like wine. The high end of the beer business is a very exciting part of the business because there is huge trading up going on in beer. Okay the consumer is definitely premiumizing, it’s premiumizing into our import. They’re premiumzing into our import brand. And craft you see the high end of the beer business being very robust. You can see it coming right out of the premium part of the beer. We definitely think that that’s going to continue and although the price differential seems big in beer, okay that’s really in percentage terms okay, is still talking about like a super affordable luxury, way, way even more affordable than wine right.”

Constellation Brands 2Q16 Earnings Call Notes

California grape harvest is expected to be down this year, but good quality

“The current California industry estimate is for total harvest yield of 3.6 million to 3.8 million ton versus approximately 4 million tons last year. While the crop is down this year versus last, quality looks to be very good with excellent color and flavors and our winemakers are smiling.”

Grape pricing flat to down though

“From a pricing perspective, we continue to expect grape pricing to be flat-to-down slightly versus last year depending on the variety, locations and demand with the exception of Cabernet, which continues to be in high demand.”

Cans provide incremental consumption occasions

“In terms of where we think the mix can get to, our Modelo brand is more of a can centric brand. We don’t really see Corona becoming a can centric brand. The purpose of the can is to just provide incremental consumption occasions for our consumers.”

Corona is by far our most important brand

“Corona is our by far most important brand. And we are going to be very thoughtful about how we proceed basically with anything new with that brand. So good news is the brand is performing better than ever right now or at least as it relates to shorter-term history. So again, Beer business is extremely strong.”

The year of the can

“I do want to come back on the year of the can, however. We’ve seen a lot of growth in Corona Extra from our year of the can program. We’ve also seen a lot of growth on the Corona Light, which was a bit of ancillary benefit that came from our focus on cans and Corona. So yes, I think there are a lot of opportunities for a future growth in our brands.”

Volume remains sort of flat so the industry is pushing more premium

“the industry is definitively premiumizing, while volume remains sort of flat so that there is a shift internally towards more premium products.”

Constellation Brands FY 1Q16 Earnings Call Notes

Bought a new wine brand, 600k cases 50% growth

“Launched in 2006, Meiomi sold about 60,000 cases in the U.S. marketplace in 2010 and has grown to become a nearly 600,000 case brand since then. It is currently the fastest growing major pinot noir in IRI channels at the $20 luxury price point and has experienced dollar sales growth of more than 50% over the last 52 weeks”

Robust demand for our Mexican beers

“We continue to experienced robust consumer demand for our iconic portfolio of Mexican beers, with our top five brands experienced — experiencing solid growth across almost all channels and packaging sizes during the quarter.”

I’m awesome

“I would also like to remind everyone that during my tenure as CEO for the last eight years, our team has created significant value by transforming and simplifying our product portfolio through the rationalization and divestiture of business assets in an effort to premiumize and grow the business. And my plan for the future is to continue to deliver value and generate growth.”

We’ve rationalize a lot of the low end of the portfolio

“that’s something that we have done over the years. We’ve really shed the bulk of the low-end portfolio. I think around, I don’t know 2008 when I became CEO and we disposed off the Almaden and Inglenook brands, which were primarily by that time 5-liter bag in the box which really represents the vast majority of the sub-premium market.”

Beer makers usually take price in the fall

“We really haven’t moved into the season where beer pricing is usually taken which is in the fall. We will of course be looking at the market as we normally do on a market-by-market, case-by-case basis. But we still fully expect that we’ll be within our guidance range of 1% to 2% on price mix”

We continue to increase advertising spend because it’s critical to maintain this “out of the ballpark growth we’ve been enjoying”

“we continue to increase our spends in advertising and marketing because we think that it’s critical to continue to drive the kind of success that we’ve had.

So in particular, the commercial side of beer is a very important part of the business for us to continue to invest in because we can’t just take our current growth and be penny wise and dollar foolish for the future. We have to make sure that we are taking all of the right steps to ensure that we are able to maintain this kind of hit it out of the ballpark growth that we’ve been enjoying.”

Paid 10x “transferred margins” for the wine company

“the purchase price pre-synergies was about 10 times the transferred margins. So post-synergies, it’s going to be significantly better than that. So it’s real good deal especially given the growth rate, which was I think 50% in IRI on over a half a million cases in the last 12 months. So, I mean tremendous deal.”

Increased marketing in wine

“I think that we will continue to see two things, okay, increased marketing and the concentration of that marketing against the smaller subset of brands. As I mentioned, we have initiated TV marketing at fairly significant rates against Black Box, Woodbridge by Robert Mondavi, for example.”